"Personal-izing" Social Security

Private accounts can work, but they're not for everyone.

Girard Miller is the Public Money columnist for GOVERNING and a senior strategist at the PFM Group.

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This is the fourth in a six-month series on reforming Social Security and Medicare.

As the midterm elections approach, the national parties are dancing around Social Security reform. A common theme among Republicans, conservatives and libertarians is the idea of allowing Americans an option to invest "their" money themselves. Many Democrats, claiming it will undermine the entire system, view it as a wedge issue favoring their candidates. The president's bipartisan commission on fiscal responsibility may consider this idea as part of a comprehensive, compromise Social Security reform proposal, although the politics of that outcome are murky, as I'll explain below.

Without taking sides, this column will present a middle way that could actually work. It's called a Voluntary Carve Out (VCO) and allows some younger workers to retain and invest a portion but not all of their Social Security contributions. I will use 1975 as the earliest birth year for eligibility, as it's too hard to make the math work for those who are older and have substantial earned interests in the current system. This also makes it clear which generation we're talking about here, as Baby Boomers are not included in or affected by this plan.

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First, we need to set forth some basic facts about Social Security that are commonly misunderstood, overlooked or misconstrued. For starters, Social Security has two components, the Old Age and Survivors Insurance (OASI) program and the Disability Income (DI) program. Taxes for OASI are 5.3 percent of payroll for both the employee and employer, and taxes for DI are 0.9 percent for each. Combined, they are called FICA taxes and, at present, apply to all earnings up to $106,800 annually. Medicare taxes apply to all earnings and are levied at the rate of 1.45 percent for employers and employees alike. When we discuss Social Security private investment accounts, it is only the OASI program and its combined 10.6 percent of payroll tax that is relevant. There is no realistic way that the Disability Insurance or Medicare programs will be privatized in the foreseeable future.

Although it was originally characterized as a social insurance system, Social Security was never a pre-funding retirement plan like a pension system. It's an intergenerational income redistribution system. Workers and their employers contribute to a trust fund but it's not actuarially structured like a pension plan. Today's Baby Boom generation has accumulated a modest surplus in the trust fund which will be exhausted in the next two decades, and younger taxpayers will provide the balance of their support thereafter. So what we essentially have today is an intergenerational "Ponzi-like" scheme in which today's workers subsidize modest retirement income support systems for today's retirees. I use the term "Ponzi" without prejudice, because it is mathematically feasible to underwrite a sustainable plan for active workers to provide income support for their elders without it collapsing. It doesn't have to be another Bernie Madoff fiasco if we have the political skills and discipline to structure it right, but many Americans are skeptical that we can. Congress has done little to prove them wrong.

The Robin Hood tax is off limits. Any effort to create personal accounts must first begin with an understanding that workers whose incomes exceed the national average (roughly $40,000 per individual) pay most of their Social Security taxes above that level to support elder retirees with lower incomes. That income-redistribution feature was discussed at greater length in my prior column on FICA freeloaders in the state and local sector, and the same principles apply here. Everybody in America must pay OASI taxes on their income above the average earnings level in order to provide the income support for America's poorest elderly citizens. I call it the Robin Hood tax: We take from the affluent workers to provide benefits to lower-income elderly. Although conservatives hate income redistribution, it's baked into the American cake. So that part of our Social Security taxes is off limits for any realistic plan to fund personal accounts.

On average, those who earn less than the national income average get a better deal from Social Security than they would likely achieve by investing their OASI taxes themselves, if you take into account the risks of unemployment, career interruptions, extended longevity and investment underperformance (especially after age 55). For lower-income workers, the administrative and investment costs of personal accounts would further erode their practicality, and they would forgo the systemic subsidy they receive when they retire. This half of the workforce is also the least prepared to bear the risks of investment underperformance, as they are most unlikely to have substantial independent assets. It makes no sense to tempt them with hopeless dreams, bad math and undue risks.

This leaves us with the OASI taxes that are levied on the first $40,000 of earned income, for those who earn that much or more. Realistically, this is the only population that has anything to gain from investing in a private account. The math is highly dependent on investment and longevity assumptions, but if OASI taxes on that income are contributed for 35 years to an account earning historical returns on stocks and bonds, it can fund lifetime withdrawals roughly equal to the corresponding Social Security pension benefit.

The math informs us that privatization of the employees' and employers' contributions on the first $40,000 of income might be put to better work for the more affluent younger taxpayers, while they still contribute their "Robin Hood" taxes on incomes above average to the Social Security income redistribution system. However, it's hardly a slam-dunk to make this work out, as there is plenty that can go wrong if markets underperform like they have in the past decade, or if these workers become unemployed or outlive their peers.

Don't mess with the payroll system. Industry marketeers and public policy analysts have spent years trying to figure out how to make personal accounts work through the payroll system. Most policy ideologues have no idea what it takes to administer these accounts through the payroll system and to reconcile them with the Social Security Administration's clunky recordkeeping systems to prevent fraud. Having toiled in the workplace retirement savings business for 20 years, I can tell you flat-out that it's a waste of time, energy and resources to try to do this at the workplace. There is a simpler, more efficient method that would work much better for the financial services industry and the Social Security Administration. The easiest way to minimize costs and make personal accounts practical is an IRS income tax credit for those who make this voluntary election.

To explain how this would work, everybody would pay their Social Security taxes through the payroll system each year, just as they do now. The same would apply to self-employed taxpayers who pay estimated taxes. Before filing their 1040 income tax return by April 15, those taxpayers born after 1975 and earning more than the national average would have an annual option to fund a qualified personal Social Security replacement account (like an IRA). By filing a simple one-page form, they would receive a direct federal tax credit which can be paid or wired directly to the taxpayer's custodial account with a qualified, bonded fiduciary institution. This would make fraud a federal crime and quickly weed out the bad guys: The FBI will be on the side of the little guy, and the tax cheats can't play games with IRS and falsify accounts to pocket the money themselves.

The amount of the annual carve-out for that year would be proportional to taxes paid. The baseline carve-out level would be $2,500 annually for those earning the national average income. This equates to roughly 60 percent of total OASI taxes paid by the employer and qualifying employee on income of $40,000. At the upper end, workers paying the maximum tax on today's Social Security income limit of $106,800 could carve out $4,000 which is 35 percent of their OASI taxes. In-between these levels we can pro-rate the numbers. These figures can then be inflation-adjusted.

For each annual election, the opting-out individual forfeits that year's Social Security OASI credits. The lifetime value of all traditional OASI benefits earned before and after that year would be reduced by 3 percent. This way, an individual who opts out of Social Security for 34 years would thereafter be completely disqualified from ever receiving any OASI benefits. This structure prevents "double-dipping" as some public employees do with their pensions, and "skimming" by those who seek to play one system against the other by manipulating their taxable income from one year to the next. Each year is a separate election for qualified taxpayers. VCO participants who opt out for 17 years and remain inside Social Security for the rest of their lives would still get one-half of their Social Security pension earned in those other years. Spousal consent would be required, since OASI provides spousal and survivor benefits, and that year's personal account contribution becomes marital property.

Rules to curb abuses. Wall Street favors the idea of personal accounts, as it will create a new niche market for investment firms, especially the large mutual funds. Instead of investing in low-yielding Treasury bonds in the Social Security trust fund, much of the money in these personal accounts will find its way into the stock market. However, it won't be a bonanza as some pundits and critics imagine: Annual net investment in stocks could increase by $30 billion annually if a third of those eligible were to open these accounts, and I suspect that would be a highly optimistic marketing goal in light of the downside risks and the public's current sour mood about the stock market. But even $30 billion a year is still a drop in the bucket compared with the IRA market, which grows by $500 billion annually on average, or the U.S. capital market with a valuation over $10 trillion. It will take an entire generation before this form of savings will have a material impact on the U.S. economy, but then it would be a clear net positive for capital formation.

These accounts must be highly regulated to ensure that they achieve their intended purpose, which is to provide a modest and secure retirement income. The financial industry will compete heartily for these accounts and should be held to high standards and low fees with no sales charges. The maximum investment expenses should be limited to one-half percent annually on assets in accounts under $20,000 and one-quarter percent for larger accounts, which will encourage use of index funds and frugal investment options. Such fee limitations will make the business viable only for firms with low-cost investment products and recordkeeping systems, which is how it should be. This program cannot become a Wall Street gravy train or a come-on for a local broker or insurance peddler. Low fees will discourage salespeople from bamboozling naïve workers to join up, just to generate commissions or uncover other household assets.

Unlike IRAs and 401(k) accounts, there would be no loan feature, no hardship withdrawals, and no early retirements at age 59½. Money could be withdrawn only by life-expectancy-based installments after age 62 or paid upon death to a survivor subject to similar limitations.

Prudent investments by design. The investment portfolio mix must be age-appropriate, with a percentage equal to the investor's age to be held in bonds, CDs or similar low-risk vehicles unless one demonstrates substantial outside liquid investment holdings of at least $5,000 times their age. The investment provider must accept fiduciary responsibility for providing suitable, prudent and age-appropriate investment vehicles for each investor, which makes them liable for losses that result from negligence, speculation, malfeasance, fraud, deceptive salesmanship and get-rich-quick investment strategies. A safe harbor can be provided for age-based target-date funds using an SEC- or FINRA-approved asset-allocation glide path.

Conversion feature for retirees. Participating retirees should have the option to convert their accounts into lifetime pensions or annuities by exchanging them for lifetime payments from the Social Security system, a state pension fund or a top-rated insurance company at fair actuarial value. Married annuitants and pensioners must obtain survivor benefits.

Popularity and politics. I have no doubt these accounts would be popular with many younger workers and especially for those concerned about Social Security's long-term solvency. The VCO option should also appeal to those who worry about some Democrats' proposals to means-test or eliminate benefits for wealthier Americans. The carve-out concept is the only way that those who distrust the entire system can be sure that they will get anything in return for their payroll taxes. Republicans see this group as a potential new investor class whose values would align with their traditional political views.

Democrats must come to realize that the more they talk about means-testing and tax increases, the more they will galvanize popular support for personal accounts among those earning more than the national median (i.e., half the working population and potentially a majority of active voters). Even though this arrangement is financially neutral over time, many Democrats will still object on three grounds. First, they revere a universal system and will instinctively resist a two-class approach that gives the affluent an option to get richer. Second, they will argue that the downside risks outweigh the upside opportunities for the middle class, and society will later be stuck with the social costs of the destitute losers. Third, they will fear that the lost cash flow will impair the current system (exposing its Ponzi characteristics) as young workers invest their money themselves. That is why I have set the eligibility and dollar limits as I have -- to preserve the safety net for those who need it and assure that the Robin Hood taxes supporting the elderly are still collected from the more-affluent workers.

As readers can see, the feasibility of personal accounts is hardly a slam-dunk. Even with careful design and protective laws, there is plenty to go wrong. There is certainly no guarantee that the hares will outrace the tortoises. Privatization proponents must accept the reality that the Social Security system must also be reformed structurally through benefits limits and somewhat higher taxes in order to make optional personal accounts viable. Otherwise the cash-flow issues will indeed be problematic in the next decade. VCOs might be a Republican bargaining chip in the face of inevitable tax increases and other reforms, but they will never fly on their own as a solution to the severe problems facing us in the coming decades.

The author's opinions are entirely his own and do not represent the policies or positions of any current or previously affiliated organization.